INTRODUCTION

Financial management was a branch of economics till 1890 and emerged as a separate discipline only at the turn of the
20th century. The traditional phase focused mainly on the planning and issuance of capital, instruments of financing
institutions, and procedures used in capital markets, and was viewed from the outsiders’ point of view. The modern face
witnessed a sea change of development drawing heavily from the economic theory and applies quantitative methods of
analysis.

The course, financial management, is of great interest to both academicians and the people in the industry. It involves a
wide range of activities like planning and raising of funds, allocation of resources effectively and efficiently to
accomplish the objective of the firm, and tracking the financial performance. Hence it may be categorized into two types
of activities: Acquisition of funds and Management of funds.

FINANCE AND OTHER RELATED DISCIPLINES

Financial management is not an independent discipline but is an integral part of overall management. It draws heavily on
the fields of study, such as economics, accountancy, quantitative methods, production, and marketing. Financial managers
work under the abroad environment and hence, should understand the structure of the banking system, capital markets
and money markets, monetary policy, fiscal policy, financial intermediaries, financial institutions, etc.

The concepts of supply and demand relationship and the principle of marginal analysis derived from microeconomics are
used in financial management to drive profit maximization strategy and help in optimum utilization of resources.

Almost all business functions like production, marketing, and human resource management revolve around the
acquisition of funds. For example, an increase in productivity can be done only by buying new machinery, which involves
the flow of funds. Likewise, advertisement and sales promotion and marketing require funds. Also, recruitment and
promotion activities of HR departments involve finance. All these functions are interlinked and can function only if the
finance function of mobilizing money to meet the requirements of all other functions can be done efficiently.

SCOPE OF FINANCIAL MANAGEMENT

Financial management helps to provide a conceptual and analytical framework for financial decision-making. Four
questions come to our minds when we think of financial management.

1. What should be the size of the organization and the total volume of funds that an enterprise requires? How would
these funds be procured?
2. What are the long-term and the short-term assets that an organization should acquire?
3. How should profit be and dividend payout be decided?
4. How is the short-term asset mix to be decided, ensuring liquidity?
Hence, the scope of financial management can be broken down into four significant decisions of finance,
a. Investment decision
b. Financing decision
c. Dividend decision
d. Liquidity decision
Let us discuss them in detail
a) Investment decision – Investment decision relates to the spending of capital expenditure on assets that are expected
to yield returns for the firms in the future. These decisions have a longer time horizon and affect the value of the firm in
the long run. These decisions are crucial and hence involve senior management. They are referred to as capital budgeting
decisions. Capital budgeting decision consists of allocating capital to long-term assets, which are expected to yield
benefits in the future. The first important aspect of investment decision is measuring the relative benefits and costs
associated with the commitments of funds which are hard to measure and can't be predicted with certainty. The returns
should be evaluated in relation to the risk associated with it. The second important point is setting up of standard against
which benefits have to be measured. It is known as cut-off rate, required rate of return, or minimum rate of return.
However, it is expressed in terms of the cost of capital. In practice, there are various problems in computing the cost of
capital, and the finance manager should watch this.
 b) Financing decision– The second major financial decision is financing. While the investment decision is concerned
about the composition of assets, the finance decision is concerned about how to acquire funds to meet the various
investment needs. The main issue is to determine the appropriate proportion of debt and equity.

The term capital structure refers to the mix of debt and equity capital. The use of debt gives higher returns to
shareholders but also increases the risk. A proper balance between equity and debt ensures a trade-off between risk and
return.

An optimum capital structure is one, which has the best financing mix, and would maximize the return to its
shareholders. In other words, it is an optimum combination of debt and equity wherein the value of the firm is maximum,
and the cost of capital is minimum.

c) Dividend decision– Dividend decision is the third significant financial management decision. It is related to the
dividend policy. The firm has two alternatives while dealing with the profit of the firm:

(i) Profits can be distributed to the shareholders in the form of dividends or

(ii) They can be retained and used for the firm's future expansion.

The dividend payout ratio, which is the proportion of profit distributed to the shareholders, will be decided based on the
preference of the shareholders and the investment opportunities available within the firm for future expansion. In practice,
only if the firm has better investment opportunities, which can provide the shareholders better returns than the markets,
profits are retained.

d) Liquidity decision – These are decisions involving a period of less than one year. These decisions are essential parts
of managing the day-to-day operation of a business. They are concerned with the management of current assets and
current liabilities. Management of current assets affects the firm's liquidity and, therefore, need due attention. If the firm
does not invest enough funds in current assets, it may lead to a lack of liquidity, and the firm may become insolvent.
Investing too much unnecessarily in current asserts would not earn anything and would affect the profitability of the firm
since it lies idle. Hence, the finance manager should develop proper techniques to achieve a trade-off between
profitability and liquidity.

All financial decisions are concerned with a commitment of funds on a continuous basis and are interdependent. An
efficient financial manager would evaluate the inter-relationship between investment, financing, and dividend distribution
functions and take an optimal decision to ensure the maximization of wealth to the shareholders of the firm.
Module 1 - Short Answer Questions

1. Define financial management.

2. Write a note on the modern approach of finance.
3. Write a note on investment decision
4. What is financing decision?
5. What do you mean by dividend decision?
6. Explain the importance of financial management.
Module 1 - Long Answer Questions
1. Contrast the salient features of traditional and modern approaches to financial management.
2. Discuss, in detail, the scope of financial management.
3. What are the main functions of the modern Financial Manager? How do they differ from his traditional counterpart?
4. What are the basic financial decisions? How do they involve risk return trade-off?
5. Finance functions of a business is closely related to its other functions” Discuss
MODULE-2

OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management, being a managerial activity, has to be guided by certain decision-making based on which a
particular course of action may be selected or rejected. The term objective is not used in the sense of the overall objective
or the goal of a business but as an operational criterion to judge the set of mutually interrelated business decisions, viz.,
investment, financing, and dividend. Traditionally, the primary objective of financial management has been considered as
“Profit maximization.” However, these days “Shareholders Wealth Maximization” has gained greater emphasis as it is
regarded as a superior goal.

PROFIT MAXIMIZATION (VS) WEALTH MAXIMIZATION

Profit Maximization

There is a general agreement that profit maximization is concerned with the efficient use of economic resources. Profit
maximization means that a firm produces maximum output for a given amount of input, or it uses minimum input for
producing a given output. It implies the efficient utilization of resources under competitive market conditions and hence,
justifies that profit is considered as the most appropriate measure of a firm’s performance. Profit is a test of economic
efficiency and thus can be used as a yardstick to judge the economic performance of a business. However, in the modern
business environment where there is a separation between ownership and management, and the firm is controlled by
professional management, the objectives are different. In practice, the objectives of various stakeholders like customers,
employees, creditors, Government, and society may conflict with each other. Hence, profit maximization is regarded as
unrealistic, inappropriate, complex, and immoral. Also, profit maximization considers perfect competition. The price
system and profit maximization principle may not work due to an imperfect competitive environment, namely oligopoly
and monopolistic, which are the common phenomenon of modern economies.

In such a situation, it is hard to have a strictly competitive price system, and hence it is doubtful if profit maximization
would lead to optimum social welfare.

Apart from the objections described above, certain limitations make it fail to serve as an operational criterion for
maximizing the shareholders’ wealth.

 It is ambiguous.
 It ignores the time value of money
 It ignores risk (quality of benefits)

Ambiguity - Profit maximization is a vague concept. It lacks precision. The meaning of the term, profit, is ambiguous.
Does it mean long-term profit or short-term profit? It may be net profit before or after-tax, total profits or profit per share
or total operating profit, and so on. If profit maximization is considered the objective, which of these profit alternatives
should a firm try to maximize? Thus a loose term like profit can’t be the basis of the operational criterion for financial
management.

Time value of Money-The profit maximization objective ignores the distinction between returns received during different
periods. This is a major technical limitation because, as per the concept of the time value of money, the value of the
benefits received today is more than those to be received in the future due to inflation and reinvestment ability. This can
be explained with the help of the following illustration.

Time – Pattern of Profits

It can be seen that both the projects provide identical returns. But while project X offers higher returns in the first year, it
can be reinvested to earn additional benefits. As a result, the two projects are not strictly providing identical returns. The
reason is the basic fact that the benefits derived earlier are better and is more valuable than the benefits received later.
This is the primary dictum of the time value of money. If the profit maximization criterion is considered as the decision
criterion, both the projects would be ranked equally. Since the profit maximization criterion completely ignores the time
value of money, this can’t be considered the decision criterion.

Risk –The most important technical limitation of the profit maximization criterion is that it ignores the quality of benefit
associated with the financial course of action. Quality refers to the certainty with which benefits can be expected. The
more certain is the expected returns, the higher is the quality of benefits. Similarly, the more uncertain are the expected
returns; the lower is the quality of benefits, which naturally implies a higher risk to the investors. Investors are primarily
risk-averse and prefer a more certain risk. This can be explained with the help of the following illustration.

From the table, it is understood that the total returns from both the projects are identical, but project X has an earning
even during the Recession. In contrast, project Y has made higher benefits under the Boom period. The range of variation
is extensive in the case of project Y and hence, includes higher risk and uncertainty. The risk and uncertainty aspects are
entirely ignored by the profit maximization criterion and, therefore, can’t be considered suitable and appropriate
operational decision criteria for financial management.

WEALTH MAXIMIZATION
Wealth maximization means maximizing the net present value of cash flows resulting from a course of action to
shareholders. Net present value is the difference between the present value of its benefits and the present value of its costs
(Solomon, 1969). Wealth maximization is a universally accepted decision criterion for financial management since it
removes all the technical flaws of the profit maximization criterion. This concept is based on cash flow generated rather
than the concept of the accounting profit which is the basis of profit maximization criterion. Why wealth maximization is
considered superior to profit maximization?

First, cash flow is a precise concept. It is an unambiguous measure and financial managers should make investment and
financing decisions in order to maximize the wealth of the shareholders. Measuring benefits in terms of cash flows
removes the ambiguity associated with accounting profits.

The objective of wealth maximization takes care of the problems of timings and risks of the expected benefits. It
considers the time value of money and adjustments are made for the uncertainty and timing of benefits arising out of a
financial decision. The stream of a cash flow is discounted to get the present value at a capitalization rate that reflects
both time and risk.

Any financial action which has a net present value above zero creates wealth for shareholders and is desirable. Any
financial action, which has a net present value below zero, should be rejected since it would destroy shareholders’ wealth.
Wealth maximization or net present value is represented as

Where C1, C2,…………Cn represents the stream of cash benefits (flows) expected to acquire from a course of action

k is the appropriate discount rate to measure risk and timing and

C0 is the initial cost (outlay) for the particular course of action.

The firm is expected to adopt a financial action only if NPV is positive, i.e. the wealth of the shareholders gets increased.
The wealth of the shareholders is reflected in the market value of shares and the wealth maximization principle implies
that the fundamental objective of the firm is to maximize the market value or price of its shares. The market value of the
share serves as an indicator of the firm’s performance. Wealth maximization principle is superior to the profit
maximization principle because it takes into account a precise concept of “cash flows” and also the time value of money .

Module 2 - Lesson
RISK-RETURN TRADE-OFF
The financial decisions of a firm are guided by a risk-return trade-off. Risk and expected return always move together.
The greater risk you take, the greater is your expected return. For example, you invest your money in shares or deposits in
banks. The return from shares is not inevitable, and hence, you incur more risk. Your decision to invest in bank deposits
is comparatively less risky, and your return is inevitable. However, you can only expect a lower return from bank deposits
than shares.

The relationship between risk and return can be expressed as follows:

Return = Risk free rate (Rf + Risk premium)

An investor, who takes a risk by investing in risky assets, essentially expects a risk premium above the risk-free rate. A
risk-free rate is a rate obtainable from risk-free government security. The higher the risk taken, the higher will be the
required rate of return. Every decision in a firm should strike a proper balance between risk and return in order to
maximize the market value of the shareholders, and such balance is called the risk-return trade-off. A financial manager
should constantly monitor funds flowing in and out and ensure a robust reporting system that will provide an accurate
picture of the firms’ performance.

Module 2 - Short Answer Questions

1. Write a note on profit maximization approach.
2. What do you understand by shareholders wealth maximization?
3. What do you mean by cost of capital?
4. List out the three limitations of profit maximization.
5. How do you compute shareholders wealth?
6. What are the basic objectives of financial management?
Module 2 - Long Answer Questions
1. Should the goal of financial decision-making be profit maximization or wealth maximization? Discuss.
2. In what respect is the objective of wealth maximization superior to profit maximization?
3. Assuming wealth maximization to be the objective of financial management, show how the financing, investment and
dividend decisions of a company can help to attain this objective